The ebbs and flows of pharmaceutical stock prices relative to their underlying fundamentals over the last two decades have provided yet another example of the potential benefits of value investing. This is the main conclusion of a White Paper signed by Brandes Investment Partners, a Value Investment Specialist with nearly $25 bn under management, established in San Diego, California, in 1974.
Additionally, according to Brandes’ review, the changing performance cycles of pharmaceutical stocks underscore the patience and fortitude required to see through negative investor sentiment and industry headwinds.
The circumstances and conditions under which the pharma industry returned to favor, as shown in Exhibit 1, came amid the great recession, the storm of confusion over health care reform, and without the fanfare or arrival of any material new blockbuster drugs. This, to us, is yet another example of how the value-investing story often plays out.
Solid Businesses Bought at Attractive Prices
Like the current situation with pharmaceutical stocks’ return to investor favor,4 with a fundamental, value- based investment strategy, there is often no need for an extraordinary corporate event, exceptional execution or especially energizing macroeconomic forces for value to be recognized in the portfolio. In many cases, it is simply a solid business bought at an attractive price that is sufficient, if given the time to perform.
Brandes points out that this could be the most instructive lesson from the recent pharmaceutical cycle. It’s been said that there really are no value or growth stocks per se, just companies with fluctuating valuations at various stages of the business or market cycle. Over time they may pass in, and eventually out, of the value and growth categories. That a company’s fundamentals would gradually fluctuate over time is not especially surprising given the dynamics and vagaries of ever-changing markets and economies. The key from a value investor’s perspective is to recognize that good companies move in and out of fashion over time, purchase them when they are out of favor and under-priced, and have the discipline to sell when they reach estimates of fair value.
Pharmaceutical Industry Performance Cycles
Brandes takes a look back at pharma stocks’ performance cycles.
Soaring Prices + Lofty Expectations = Rich Valuations
Almost 20 years ago, in a contentious and politically charged healthcare environment strikingly similar to today, pharmaceutical stocks sat poised on a launching pad in the eyes of investors, seemingly ready to either vault into the stratosphere or implode at ignition depending upon the fate of the pending health care reform legislation colloquially known at the time as Hillarycare. When the plan was defeated in 1994, share prices of the major pharmaceutical companies within the MSCI World Index soared starting that year and as the decade of the 1990s came to a close, as these companies were freed from the perception of potentially excessive governmental regulation and benefited from a roster of blockbuster drugs.
At the start of the new millennium, pharma share prices within the MSCI World Index hit all-time highs in the early 2000s as the growth prospects for an increasingly sophisticated and vitally important industry, just a few years away from catering to a soon retiring baby boomer generation, looked brighter than ever. Although Brandes Investment Patners were attracted to the fundamental business case for many of these companies, the high prices the market ascribed to them kept them from including these companies in the portfolios at the time.
Uncertainties Had Driven Prices Down by the Mid-2000s
As it’s inclined to do, however, uncertainty then visited the thriving pharma industry in the form of competitive and regulatory challenges, and as the first decade of the new century progressed, both the outlook and share prices for large pharmaceutical companies within the MSCI World Index changed course and fell considerably by the mid-2000s. During that time, significant market concerns including the following began to weigh on pharma share prices:
- Looming expiration of valuable drug patents
- Declining research & development (R&D) productivity due to longer and more expensive clinical trials and greater U.S. Food and Drug Administration scrutiny
- Renewed and even more substantial healthcare reform pressures in the United States and globally
The market responded by re-rating pharmaceutical companies to much lower multiples than it was willing to apply beforehand. Suddenly, the Golden Age of Pharma was ending and the previously bright outlook for a rapidly growing industry was dimming, and their share prices responded accordingly starting in the mid-2000s, as mentioned above.
At the time the Brandes Global Equity Strategy began purchasing a number of the major pharmaceutical companies in 2004, the 12/31/2004 forward price-to-earnings ratio of the MSCI World-Pharmaceuticals had dropped to 16.2x. As is usually the case, P/Es had come down from lofty levels because the outlook for pharmas was not nearly as sanguine as it previously had been.
Fast Forward to 2013, Pharmaceutical Stock Prices Have Risen Again
Year to date through the end of the second quarter 2013, while pharma stocks within the MSCI World Index were on an upswing, their recent full cycle from high flyer, to laggard, and back again, is retracing a fairly familiar value pattern. A number of factors may have influenced renewed investor interest in pharma companies recently. These include the resiliency of the businesses amid changing investor perceptions, cash flow generation, conservative balance sheets as well as increases in dividends and share-buyback activity, as shown in Exhibit 2. Despite the recovery in share prices, Brandes Investment Partners still finds these companies attractively valued and they represent a meaningful allocation in the portfolio.